Letter of Credit vs. Letter of Guarantee

Posted by Factor Funding Co. on May 28, 2013

Do you operate a resale business? If so, you may have an existing relationship with both your suppliers and your customers. However, in order to conduct business successfully, you, your customers, and your suppliers usually need to have and use credit. Some of the common forms of credit used in resale merchandising include letters of guarantee and letters of credit. Understanding the similarities and differences of these letters is important in deciding whether or not to use them in your normal business operations.business letter of credit

How These Letters are Similar

Both these letters serve as written forms of business credit. A letter of credit is a written promise that if your customer doesn't hold up his or her end of the bargain by paying, you'll be able to collect your payment from the bank. This gives you a foolproof way of getting paid, no matter what your customer decides to do. This recourse option is similar to what is offered by a letter of guarantee. In this case, the bank will cover the unpaid debt of your supplier. This is particularly important since you often have to submitpayment for your supplies upfront before the supplier ever sends out the goods.

How They're Different

There are a few important distinctions between these two credit letters, though. A letter of credit is backed up by collateral or credit from your customer. This means that the bank that issues the letter has received some kind of basis for extending the credit. So, after the bank covers your customer's unpaid bill, it often has a way of recouping its funds by seizing one of your customer's assets.

However, when a letter of guarantee is issued, there is no underlying asset for the lender to recoup. If your supplier defaults by not shipping out your goods, then the lender is required to refund you your money, even if it is unable to recover that payment from the supplier. Because of this difference, most lenders are unwilling to issue a letter of guarantee unless the supplier has an excellent credit history and a record of delivering goods in a timely manner.

If you decide to accept a letter of credit from a customer, you can rest assured knowing that you won't be stuck holding the bill if he or she decides not to pay you. A letter of guarantee offers a similar reassurance, promising that the backing institution or individual will refund you if you never receive your supplies. Both credit letters can be helpful in avoiding unnecessary business expenses or losses.

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